INVESTMENT BANKING

Investment Banking: The Management of Capital - Study 2



Investment Banking: The Management of Capital

Answer 1:

Traditional Policy Tools Used By Central Banks

The traditional policy tools used by Central banks around the world are discount window loans and the interest rates attached to those loans; reserve requirements that compel banks to hold cash reserves as a defense against liquidity shortages; open market operations involving security trading to nudge interest rates up or down; and moral suasion or psychological pressure on financial managers and others to conform to the central bank's policies.

Advantages of Traditional Policy Tools

The Federal Reserve “the Fed” is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable financial system. Specifically, the Fed was dually mandated to promote stable prices and maximize employment. Today it is charged with the primary task of regulating monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates. The Federal Reserve System operates offices in 12 regions so that each region has the facility to borrow short-term loans. Such loans expand the cash reserves available to banks to make new loans or cover bank debts. The interest rate attached to these loans is known in the United States as the discount rate and changes in this rate soon spread to other short-term rates in the financial system, pushing other rates higher if the discount rate is increased and pressuring other rates lower if the discount rate is decreased.

The benefits of reserve requirements are that when the reserve requirements are raised banks must come up with the additional cash, which tends to increase market interest rates and slow money growth. Similarly, a lowering of reserve requirements tends to decrease market rates of interest and increase growth in the nation's money supply, other factors held constant.

The advantages of open market operations include Sales of government and other securities tends to contract the supply of reserves banks have available for lending and tends to push interest rates, especially short-term rates, upward, while open market purchases by the central bank tend to expand bank reserves and lower interest rates, stimulating the economy.

The benefit of moral suasion is that it is an effective tool for dealing with individual financial firms.

Disadvantages of Traditional Policy Tools

The drawbacks of discount window is that over the years the discount tool has been conservatively managed, even in times of crisis, and it has seemed to lack the flexibility necessary to deal with difficult problems in the financial marketplace.

The disadvantage of reserve requirements tool is its little usage today because of the unpredictability of its effects and its inflexibility; for example, normally it cannot be used on a daily basis to deal with sudden market changes.

The drawbacks of open market operations is that the Fed has tended to emphasize trading in short-term government securities and is not always effective in affecting other ...